John Taylor, Pariah Amongst Piranhas

Lots of heat directed at John Taylor for a recent blogpost about financial crisis and recoveries. Check it out:  http://johnbtaylorsblog.blogspot.com/2012/10/simple-proof-that-strong-growth-has.html
Here's an older, better post on the same thing:
http://johnbtaylorsblog.blogspot.com/2012/08/its-still-recovery-in-name-only-real.html
And here's some of the reactions, many of which raise some valid points: http://krugman.blogs.nytimes.com/2012/10/17/financial-crisis-denialism/
http://misleadingguidetocurrentaffairs.blogspot.com/2012/10/the-muss-method-and-john-taylor.html

Taylor's argument is that that financial crises needen't cause a prolonged slump in output below its potential. Its true that his methodology in the second post was sloppy. The 1973 oil price shock and the 1981 disinflation were not financial crises. Maybe he is guilty of intellectual malpractice, or of trying to manipulate evidence to make his case stronger. But I find his premise that a prolonged slump in the wake of a financial crisis is unnecessary if policy responds appropriately convincing. Por ejemplo, take these three examples: 1893, 1907, and 2008. These three crises WERE financial crises that did result in economic slumps!                                                                 

We currently have unemployment at about 7.8%, or several points above anyone's best guess of the NAIRU. Consensus opinion is that the labor market is still in disequilbirum, with desired quantity demanded less than desired quantity supplied. What is the mechanism that is supposed to bring the market for work into equilibrium? It's the real wage, or the nominal wage / price level. A coherent story about the slump is that the financial crisis caused credit markets to contract and firms to lower expectations of future earnings. This caused a decline in the demand for labor, but because nominal wages are sticky and the price level did not rise, real wages failed to adjust, so more workers are seeking employment than firms want to use as inputs to production. If real wages were perfectly flexible, they would fall in the wake of the crisis, making workers more attractive to employers and causing the remaining jobless to remain so as a result of their leisure/consumption preferences. We had a demand shock. Prices didn't adjust, so we still have a slump. Monetary and fiscal policy (both changes in taxes and targeted spending) can boost aggregate demand. If they haven't, policy makers should be made to answer why. 

The financial crises and recoveries above demonstrate that it IS possible to have a rapid recovery. Maybe prices and wages were more flexible in the past, so demand shocks were not so disequilibrating. But bold movements on taxes, spending and monetary policy can and should go a long way toward mitigating a slump, whatever its origins. Just because poor past policy in other crises may have lead to slow recoveries doesn't mean current policymakers should get a pass. And those who want to throw up their hands and say "It's just how it is after a crisis" are giving a blank check to those in power. A check drawn on the empty account of the unemployed.

Update: John Cochrane weighs in with what I think is the best commentary yet. Here's my favorite excerpt

"If you conclude "recessions are always long and deep after financial crises" then you're saying policy doesn't really matter...so you shouldn't be advocating different policies! If policies matter a lot to the length and severity of recessions, then "recessions are always deep and long after financial crisis" is a meaningless statistic, and a poor fig leaf of an excuse."

Who's Afraid of Inflationary Finance?

The Germans, of course. I'm a tad late to this party, but now's as good a time as any to jump in. It seems the German central bank (ReichsBundesbank ) has challenged the ECB's newest bond-buying scheme (which to my understanding consists of the ECB selling German bonds and using the proceeds to buy up Italian and Spanish debt to suppress yields) in the German Constitutional Court. Check it out:

http://www.independent.co.uk/voices/comment/the-bundesbank-is-calling-the-shots-now-8125952.html

Apparently, the head of the Bundesbank, Jen Weidsmann, has threatended to resign over what he calls "state financing via the money press." Of course, inflationary finance is a touchy subject for Germans, given its history with hyperinflation from 1921-1924 under the Weimar Republic. And of course, as everyone knows, it's that hyperinflation that lead to the collapse of democracy in Germany and the rise of Hitler!

Except that's not true. Hyperinflation in Germany ended in 1924, when Germany revalued and issued a new currency called the Rentenmark, at an exchange rate of 1,000,000,000,000 reichsmarks = 1 rentenmark.

Hitler was not elected as Chancellor of Germany until the 1932 elections, taking office on Jan. 30, 1933. That's a full nine years after the end of hyperinflation, in the middle of the deflationary Great Depression. Whats the connection between the election of 1933 and an inflation that occurred a decade earlier?

Lets get the history straight, shall we? Inflationary finance did not bring about the Nazis; mass unemployment did. Crushing debt burdens owed to foreigners did. Foreign mandates imposed in a beleagured population did. THAT'S the kind of environment that leads to radical leaders who's messages of spite and hatred can take root.

Europe, NGDP, and the Euro-Crisis: the AEI's Cool Chart

James Pethokoukis, a blogger for the AEI, has a lengthy post about NGDP growth and the Euro crisis that I'm sure is good, but I was more interested in this awesome graph. Check it.

As expected, the slowdown in NGDP was accompanied by the ballooning of debt/GDP ratios. 

John Taylor on the Myth of Financial Crisis Recoveries

John Taylor has a fascinating new post on the weak recovery and compares it to severe recessions of the past. One frequent claim heard (and one I believed until I saw this post) is that recovery from recessions caused by financial crisis necessarily takes longer to recover from. But check out these time series and judge for yourself.

Clearly something is rotten in the United States.  

Draghi Acts, the Market Reacts

I'm not going to beat a dead horse and repeat my same analysis of the Eurozone monetary crisis, NGDP, ect. But take a look at this, so it feels like Eurozone economic recovery is so close.

http://www.reuters.com/article/2012/07/27/markets-bonds-euro-idUSL6E8IRC1R20120727

Happy Bastille Day!

Now if we could just get the French people to be one-fifth as passionate about changing the policies of the ECB as they were about the policies of King Louis XVI. Oh well.

Alexander Hamilton is no Guide for Europe (part 2)

Last post I mentioned how fiscal unification in Europe would lead to tensions between member states as disagreements over taxation, spending, regulation, labor policy, ect. inevitably arose. But more to the point, the circumstances under which Hamilton proposed Federal assumption of the state's debt beres little resemblance to the present situation in Europe.

Lets investigate why. Alexander Hamilton made his proposal in First Report on the Public Credit in order to create a system that would build the credit record of the new country. By proving the Federal government could borrow and repay international and domestic creditors, future borrowing would be possible on better terms for both the government and private borrowers. The debt burden at the time (equivalent to about $4.1 trillion in todays dollars) which the United States had no problem servicing at an interest rate of 4%.

Contrast these circumstances with those faced by Europe. All the European nations have long and established credit histories (some of which are good, some bad, all of which the bond market considers). They've got nothing to prove. Their issue is not to demonstrate their capacity to service debt at face value, but to services a nominal stock of debt that has become unsustainable given the decrease in NGDP growth (and hence nominal government revenues) since 2008. So basically the European periphery + France (I have no doubt Britain will opt out) can cede fiscal independence to Germany in a pact that will lead to tensions and pan-national resentments, or the ECB can do it's job.

Your move Draghi.

Alexander Hamilton is no Guide for Europe (part 1)

Oh dear. I came across this today (http://www.businessweek.com/news/2012-07-06/europe-recalls-hamilton-as-desperation-turns-on-the-debt ) and thought it needed an immediate commentary. It seems that some European policymakers/ deep thinkers are trying to use the plan Alexander Hamilton created to unify the 13 former colonies into the United States as a way to solve Europe's debt crisis.

This is fatally flawed plan, for several reasons.

Let me start by saying Alexander Hamilton is my favorite Founding Father, by far. His vision of the United States as a strong, unified nation that earned it's income from commerce and manufacturing, with the whole economy bolstered by a strong public sector and robust financial system, is the vision that we have fulfilled (as oppossed to Jefferson's ideal of an agrarian republic). And his plan in 1789 that the Federal government would assume the debt of the individual states in return for the states' granting the Federal government more power of their affairs was undoubtedly crucial for the development of the US and was a visionary plan.

But a modern corrollary is an inappropriate step for the Eurozone. For the individual nations of Europe to cede power to some kind of Federal institution as yet to be created in return for German money to meet their debt obligations will end in ruination. Here's why the plan is doomed to fail, in several sections.

1. The path to unification is a rocky road. Think I'm wrong? How did it work for the United States? The Federal government began legislating for all the states in 1787, after the Constitution was ratified. Immediatley, disagreements between north and south emerged over tariffs, taxes, military spending, and shall we say.. labor policy, among other things. The whole "disagreement" lasted about 70 years and eventually devolved in a bit of a tiff featuring guys who looked like this:

Can you imagine Germany having similar disagreements with Italy, Spain, et al? Because I sure as hell can. Think it wouldn't devolve into a civil war? Its unlikely, but then again such outcomes always seem to be. 

Money in Europe is TIGHT! (And Interest Rates are a Useless Guide)

I had not been previously able to find the stats to investigate this (even though they were on FRED the whole time, under my incompetent nose). I did a few data transformations (in an attempt to paint the picture I wanted to see in order to create a picture of whats going on. Here's what I came up with.

Two things. 

1. This chart seems to corroborate what Milton Friedman  Scott Sumner always says about interest rates being a piss poor  misleading guide to the stance of monetary policy. I mean, just look at that correlation. Interest-rates plunged along with the growth in the money supply; and that even going by the change in quantity of euros, not a percent of the total! 

2. Europe is clearly literally suffering from contractionary monetary policy; their M2 supply is growing at a vastly slower rate than pre-crisis, again, in terms of quantity, not just rate. 

But hey, interest rates are still low, so money must be easy, right? Right?

The Eurozone Crisis Is NOT an Economic one (part 1)

At least not in an authentic economic sense. Not when we define economics for what it actually is, as the production and distribution of goods and services.

I'll be clear.

All we keep hearing from the chorus that includes everyone from the highest chamber of government ot the lowest of the punditry class is that the Eurozone faces a deep, intractible problem that that is the reason so many Europeans must remain unemployed, fiscal austerity must continue, Germany must keep forking over more bailout funds, ect. But in a real sense, there is nothing different about Europe then there was before the crisis.

A few quick questions.

Have Greece, Italy, Spain, and Ireland experienced a massive destruction of their physical capital stock over the past five years? No.

Have their labor supplies been cut by a pandemic or have their workers suffered a collective bout of amnesia that has robbed them of their technical skills or business knowledge?

Has the level of technology drastically reverted in a Dark-Age style atrohpy of productivty? No.

Then Y = f(A,K,L) has not changed in any meaningful sense. If anything, technology, and the potential labor supply have only continued to grow over the course of the crisis. So in a real sense, there is no economic problem, if we understand an economic problem to be a failure of a country's ability to produce goods and services.

To be continued...

A Doited German Rules Them all...

Since their monetary policy was sent abroad.

You'd thought I'd forgotten about this. But I haven't. Here's the latest news from disaster ridden Spain, where tight money on the part of the ECB continues to wreak unfathomable havoc. Check it out. 

http://www.moneymorning.com.au/20120502/expect-eurozone-panic-as-spanish-house-prices-tumble-with-its-economy.html

Europe needs monetary expansion NOW NOW NOW and for the foreseeable future, i.e. until unemployment comes down, real incomes expand, and growth resumes. Full stop. 

But the Boys from Brazil  Frankfurt still see no problem. Nice going Draghi. 

Paul Krugman on Europe

And we're back to Europe. Here's an interesting takedown of the continuing Fourth Death of Europe (no points for guessing what the first three were).

http://www.nytimes.com/2012/04/16/opinion/krugman-europes-economic-suicide.html

Crisis and Regulation, part two: Enter the Investment Banks

At the end of Crisis and Regulation Part One I said that mortgage lenders packaged mortgages they had made together into mortgage-backed securities, and then sold them to "someone else." This meant that because they quickly unloaded the mortgages, mortgage standards declined, which many loans given to the NINJAS. The "someone" who bought these mortgage securities were the investment banks- think Goldman Sachs, Bear Sterns, Lehman Brothers, Morgan Stanley ect.

Now a word about invesment banks: the process of investment banking is essentially the inverse of the process of commerical banking. Investment banks purchase securities from issuers and then sell them to the final investors. For example, investment banks are how firms sell stock when they wish to issue more: Goldman Sachs will purchase x number of shares from Apple and then sell those shares to the general public; the margin between the purchase price from the issuer and the price they get from the public is their profit. So investment banks act as an intermediary between those selling assets and those wishing to buy them, as opposed to commerical banks that act as an intermediary between people buying assets (depositors) and those selling them (borrowers). But the big difference between investment and commercial banks is that investment banks do not hold assets on their balance sheets for very long; its a quick-turnover business, at least if done profitably: they want to flip the securities they have underwritten to a buyer quickly to get the margin of profit, as opposed to commerical banks who hold their liabilities (deposits) and assets (loans and other securities) on their balance sheets for a longer period of time.

But what are the implications of this for the financial crisis? Well, the investment banks were the critical link in the securitization chain that spread the risk of mortgage default from the originators of the mortgage to the broader financial system; if the investment banks had not underwritten the mortgage securities from the originators and sold them to other investors (such as commerical banks, pension and mutual funds, sovereign wealth funds, ect) the financial contagion would not have happened...

but why was it all able to go so wrong?

Crisis and Regulation, part one

I watched Inside Job for the first time this week, and it got me thinking about financial regulation and the crisis of 2008. What struck me most about the whole thing was how ill-designed the subsequent Frank-Dodd regulatory bill was.

To start with, lets investigate my diagnosis of what caused the financial crisis, and what did not. The crux of the problem was asymetric information, where one side in a transaction has more information than the other. With asymetric information, markets cannot funciton efficiently because supply and demand equilibrium rely on both parties maximizing their utility; with asymetric information, prices will either be too high or too low, depending on whether the buyer or seller has the information advantage.

This was exactly the situation that arose in the market for mortgage-backed securities. Mortgages of individual homeowners were combined into securities and sold by the original lending institution. The mortgage payments from the mortgages that comprised the security than went to the new owners of the security.

Many of these securities were backed by mortgages that were given to NINJAS- no, not those ninjas, but people with No Income, No Job, No Assets- obviously the type of person who is likley to default or at least be delinquent on their mortgage. But the originators of these loans did not care, because once the made the loan, they simply combined the bad mortgages into mortgage-backed securities and sold them to someone else.

Ben Bernankes Gets Historical

This is kind of cool, I guess Ben Bernanke is giving a series of speeches on the history of the Federal Reserve, starting with the history of the gold standard. This is an area I have studied before; the lessons of the gold standard have particular relevence to the eurozone crisis today because of the parallels between fixed-exchange rate systems. More on this later.

http://www.businessinsider.com/ben-bernanke-murders-the-gold-standard-2012-3

Draghi (unintentionally) Blunts his Own Lance

In the past week, I pointed out what I believed to be a high expansionary action on the part of the European Central Bank when I lauded their decision to "flood" the European banking system with up to a trillion in new open market operations. This kind of monetary expansion is just what Europe and especially the Periphery need in the face of sustained unemployment and low inflation, not to mention the collapsing confidence of the bond market.

But as if in an effort to stymie this achievement, Mario Draghi has gone and made it explicit that the ECB does not plan on taking any future action; the onus is once again the the debt-constrained and depressed economies of the Periphery. Awesome. Bondholders that may have taken the ECB's recent expansion as a signal that the ECB won't allow another recession and won't allow a debt-crisis are being told not to get too optimistic; the ECB might just back out yet. Check it out.

http://www.reuters.com/article/2012/03/05/us-ecb-rates-idUSTRE82418G20120305

Draghi Answers the Call

The other day the ECB ended its bond-buying program, and I was bearish on the future of the eurozone economy in light of it. But I am more than pleased to see this today:

http://www.guardian.co.uk/business/2012/feb/28/european-central-bank-euro-eurozone?newsfeed=true

Mario Draghi has committed the ECB to another round of aggressive bond-buying, or "quantitative easing." This is highly expansionary policy at work, and I could not be more pleased.

It seems the ECB may have a chairman who is committed to stabilizing Europes economy and understands the critical role monetary policy has to play in the soverign debt crisis of the periphery. Well done Draghi, and keep up the good work.

I've been saving this picture for a special occassion. This certainly qualifies.

Eurozone Economy on Verge of Second Recession

As predicted, the Eurozone economy seems poised for another contraction. Check it out.


http://www.reuters.com/article/2012/02/22/us-economy-europe-idUSTRE81L0R020120222


France and Germany, the bloc's two biggest economies and drivers of growth, failed to grow at all last quarter; overall eurzone unemployment is at 10.4%, with core inflation running at 1.9%.


I especially like this quote: "The euro zone economy contracted 0.3 percent in the dying months of 2011 so a second quarter of contraction would meet the technical definition of recession."


Recession is looming and inflation is low; now it the textbook time for expansionary policies. The message everyone European should be sending to their policy makers is this: Expansionary Policies Now!

Mario Draghi, you're on deck. 

ECB Halts Expansionary Policy

This is deeply, deeply, troubling. Click the headling below to see what I'm talking about.

http://www.cnbc.com/id/46453949

Now I have covered two different models, IS-LM and market monetarism, both of which strongly suggest the need for monetary expansion in a depressed economy with high unemployment and low inflation. Europe, as everyone nows, still strongly resembles such an economy.

Thats why Jean Claude Trichet's rate hike last year was so wrong headed, and why I attribute much of the blame for the continued crisis in the Eurozone to his tight money policy. But when Trichet was replaced by Mario Draghi in Novemeber of last year, I thought maybe a change in the winds was on the horizon; and for a while, it seemed to be true. Draghi announced that the ECB would begin a program of bond-buying aimed at purchasing at-risk government debt, namely securities issued by Spain, Italy, Ireland, and Greece.

This program served to both increase the nominal money supply (non-inflationary in such an environment, but highy expansionary) and to take some of the pressure off bond markets to load up on all the risky debt, breaking the cycle of self-fullfilling panic. And for a while it seemed to be working.

But today, the program, and implicitly the expansionary policy mindset I'd hoped would be Europe's salvation, has abruptly ended. More on this story as it developes.

Ben Bernanke should target the dollar/euro nominal exchange rate

Ben Bernanke should announce an explicit target for the dollar-euro nominal exchange rate. One that is substantially below the present parity of about $1.30 to a euro. He would do this by purchasing Italian, Spanish, Irish, and (possibly) Greek debt with open market operations, i.e. by expanding the Fed's balance sheet. This would do several things:

1. More M for the M/P part of M/P* V(i) = Y. Market monetarists will be pleased.

2. We've done all we can do on interest rates; why not target exchange rates? Boost NX instead of I in C+I+G+NX. Keynesians will be pleased.

3. The periphery will recieve a repreive from their looming debt crisis and see a fall in interest costs. Crisis averted.

4. Northern Europe (especially a certain German Chancellor)  will flip out about the "competitive devaluation" and (hopefully) pressure the ECB to return fire, i.e. expand.

It sounds foolish, but it just might be a way for central banks on both sides of the Atlantic to do the kind of expansion the both economies still desperately need.